RMPM, Part VIII: Revisiting My 401(k) Account

Contributed by mm | February 24, 2007 4:55 PM PST

I have to give some credit to our benefits department for taking an active role in maintaining a good 401(k) plan. Over the last couple of years, they sacked the ill-performed Fidelity Magellan fund, negotiated a lower expense rate on the money market fund, and introduced a series of Barclays LifePath lifecycle fund. Overall, they provided good service in delivering a reasonably good plan.

But it is far from saying the investment options provided in the 401(k) plan are all top-notch funds. Below are Morningstar's latest take on the mutual fund options in my 401(k) plan:

Only one third of the funds are given a 5-star rating, and half of the funds are barely keeping up with the average. In addition, a handful of funds are reporting negative alphas (meaning a systematic unfavorable bias in keeping up with index), and some have low Sharpe ratios (meaning not getting enough financial rewards for taking risks). All in all, I really cannot say I am afforded the best investment options.

So, how can I make the most out of the 401(k) plan? After all, the $90,000 we invested in the plan is virtually all our assets in before-tax accounts, and we do hope to grow them quicker than the rest of the portfolio to take full advantage of the preferred tax status. After all, we probably won't touch one dollar of what's currently in the 401(k) accounts before we turn 60.

One option is to only invest in the 5-star funds in the plan, and balance it with the rest of my after-tax portfolio to accomplish fair coverage of all asset classes. This means we will rely on the plan's strength in large-cap and small-cap growth companies, and intermediate bond areas. However, this is not the right mix you can count on to deliver long-term above-par performance in your tax-deferred account.

I actually have one more revolutionary option to turn my money in 401(k) accounts to really good use. That is, to roll over the money to a traditional IRA. The rollover door is open to me because technically I am no longer with my employer's U.S. subsidiary that provides the 401(k) plan, and I'm labeled as an ex-employee in the 401(k) plan.

A complete roll-over brings several benefits:

First, obviously I will have access to the whole range of investment options. I can select mutual funds and stocks as I see fit to accomplish my portfolio goals, instead of trying to fit my aspirations to the limited choices afforded in the 401(k) plan. Will I miss the access to some institutional-class fund options and their lower expense ratio? No, a good fund's positive alpha will more than make up any tiny difference in expense ratio between institutional-class and retail-class.

Second, it will bring me one step closer to a final Roth IRA conversion. While 401(k) or IRA allows for tax-deferred growth, it is still before-tax, and I look forward to the chance to shift the tax-deferred growth to tax-advantaged growth available in Roth IRA, and doing so will allow me to grow the account tax-free for the rest of my life. In the near future, I couldn't do so before our household's income exceeded the IRS threshold. However, Congress passed the law to allow Roth IRA conversion in the year of 2010 with no income limit (read: so the government can tap into some future tax dollars much sooner to mitigate some budget deficit). Furthermore, I will for sure retire in the next 5-10 years, and I will have sufficient opportunities soon to do a Roth IRA conversion when my marginal tax rate is at 10% or 15%.

Third, much less obviously, a traditional IRA provides better estate planning options, like to allow your heirs to extend the required minimum distribution over their expected lifespan by using what's called Inherited IRA.

Therefore, I am pretty much determined to roll over both my wife's and my 401(k) account to a traditional IRA.

Next: Finding the best mutual fund options for my Rollover IRA and my after-tax portfolio.

This Post Has Received 8 Comments. Share Your Opinions Too.

2million Commented on February 25, 2007

Do you really think your marginal tax rate will ever be 10-15%? If you retire with $1-$2mill in investable assets plus continue to run your side business you will surely be bringing in enough income that you will at least be in the 25% marginal tax rate?

Perhaps your thinking you will have sufficent oppurtunity to shift income to previous or future years to reduce your income for a small period of time? :-)

MM Commented on February 25, 2007

Good question.

A tax-efficient $1.5M portfolio should generate no more than 2% taxable capital gains and 1% dividends, so this adds up to $45k at most (and capital gain part is taxed at 5%!). The value-minded mutual funds I'm looking at are mostly tax efficient.

For sideline income, I already set up a C corporatin and SE 401(K) accounts so nothing will show up in my 1040 if I don't want to.

I need to have $70k in AGI before i reach the 25% tax bracket (adding the $10k standard deduction), so i do have some wiggle room to convert my traditional IRA to Roth IRA gradually at a favorable tax rate.

JM Commented on February 25, 2007

Thanks for the article, any chance you could use some of the same information if you started up a 403(b)? Also, if doing the same is possible with a 403(b), would it be a tax friendly idea to turn it into a Roth IRA?

MM Commented on February 25, 2007

It should apply to 403(b) too, but whether it is tax beneficial depends on your own situation. Not all conversion will be tax friendly.

Andrew Commented on February 25, 2007

Have you thought about making non-deductible contributions to a traditional IRA for years 2006-2010 and converting to a Roth IRA in 2010? If I understand this conversion correctly, you would only have to pay conversion taxes on the earnings from those contributions -- not the entire IRA value.

Essentially, you have the ability to skirt the Roth IRA AGI limits. However, if you already have substantial traditional IRA accounts it is not as effective as the conversion is pro-rated over all IRA accounts.

With that being said, if this is something you are not aware of you may think twice about moving that 401k account to an IRA and keep it placed in your 401k until 2011.

JM2 Commented on February 26, 2007

Another question, why a C Corp as opposed to an S Corp? If you haven't touched on that, I would be interested in hearing your thought process. Thanks!

MM Commented on February 26, 2007

Andrew, yes, non deductible IRA contribution starts to become attractive with the pending removal of Roth IRA conversion income cap. I will discuss it in this series later.

JM2, C corporation brings many benefits, including control over timing of income, the capability to expense many benefits (child care, flex account, etc.) Take a look at this post:

http://www.pfblog.com/archives/3865_tax_strategy_for_selfemployment_income_part_9_c_corporation.shtml

Adam Commented on March 24, 2007

It would be crazy to roll your 401K/IRA into a roth in 2010 when your tax rate is so high. Any advantage a better fund would have over your current options would never make up for a 10-15% higher immediate tax hit. Also, five star funds have a tendency to become three star funds after a couple of years...